Heartland Small Cap Value Strategy 4Q16 Portfolio Manager Commentary

 Executive Summary

  • The portfolio’s holdings were up on an absolute basis but the Strategy lagged its benchmark, the Russell 2000® Value Index, returning 4.19%† versus 14.07%.
  • Valuations point to much of the easy money having already been made.
  • We continue to focus on companies serving unique niches, with exceptional balance sheets, and that are capable of generating strong free cash flow.

“It is impossible to produce superior performance unless you do something different from the majority."
—Sir John Templeton

Fourth Quarter Market Discussion  

A surprise outcome in the presidential election unleashed a wave of optimism that pushed markets to new highs. Many investors cheered the incoming administration believing it would usher in tax reform, fewer regulations, and relief from the Affordable Care Act. The reaction was swift and powerful.   

Less government influence in the economy was viewed as a catalyst for growth and, as shown below, cyclical areas benefited most. The December rate hike, and expectations of more to follow, boosted Banks as investors bet on a rise in interest income.  

Reversal of Fortunes  

Heartland Small Cap Value Strategy Portfolio Manager Commentary Declines Chart

Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®
Holdings data as of 10/3/2016 to 11/7/2016 and 11/9/2016 to 12/30/2016
Past performance does not guarantee future results.

The new administration should breathe life into an underperforming economy. However, valuations appear stretched. Against this backdrop, we believe finding compelling opportunities will require fundamental research—and not a passive approach.

Portfolio Activity

The Portfolio’s holdings were up on an absolute basis but mixed relative to the benchmark, the Russell 2000® Value Index. Stock selection in Financials, Energy, and Utilities boosted performance. Health Care names detracted due primarily to a company specific issue with one of our companies.


Heartland Small Cap Value Strategy Portfolio Manager Commentary health care iconTrinity Biotech PLC (TRIB), a developer and manufacturer of diagnostic products, fits our strategy of holding businesses with competitive advantages that should allow them to grow faster than peers. The stock was down sharply after it announced it was pulling its bid for Federal Drug Administration (FDA) approval of a test used for rapid detection of heart attacks in emergency room settings. The test showed promising results, but the company rescinded its application based on an FDA recommendation.

The decision was a disappointment, but the market’s reaction, in our view, is overblown. Trinity remains a premier player in diabetes testing. It also dominates the HIV diagnostic market in Africa and controls a third of the segment in the U.S. The company’s infectious disease line generates $43 million in annual sales—half our estimate of the Dublin-based business’ intrinsic value.

Trinity’s position as a global leader in diagnostics should help it quickly establish itself in new markets such as Brazil. Looking solely at the company’s earnings power from its diabetes line, we believe the stock is trading at a 50% discount of its worth using peer-average multiples.

Cashing in on the cloud

Heartland Small Cap Value Strategy Portfolio Manager Commentary IT iconInformation Technology holding RadiSys Corp (RSYS) lagged despite seeing an inflection in earnings this year. The developer of high-performance software and integrated systems for the telecommunications space has undergone a transformation over the past five years.

As the wireless industry began to transition away from integrated hardware to widespread use of software, the company adapted to keep pace. During the period sales and earnings declined while RadiSys built up its software line. However, 2016 marked an inflection point. Aided by a multi-year contract for upgrading a Verizon data center, the company finished the year on pace for a 16% jump in revenue.

In the coming years, traffic on mobile, fixed-line, and cable networks is expected to explode. The increased volume should help the company consistently grow sales in the mid-teens compounded annually. Additionally, the business’ software sales are gaining traction. The company has already landed two critical clients in the space and several more are expected to come aboard in 2017. Based on our price to sales analysis, the stock is trading at a discount of approximately 35%.

Looking past the banks

Heartland Small Cap Value Strategy Portfolio Manager Commentary financials iconStock selection in Financials was strong but the group detracted due to a material underweight to the area. The sector makes up almost one-third of the benchmark. We believe an allocation that size would create undue risk for investors and we remain underweight to the sector.

The rapid rise in bank stocks has led to fewer compelling values in the space; however, we continue to find opportunities in other industries in the Financials sector. Radian Group Inc. (RDN), a private mortgage insurance (PMI) company, is a good example.

We have been impressed with its growing book of insurance in force and believe prospects for an uptick in new insurance written are strong. Additionally, a rise in interest rates should help PMI companies as homeowners will be less likely to refinance mortgages. A slowdown in refinancings should lead to insurance policies on existing loans remaining in force for longer.

Radian announced earnings that were better than Wall Street analysts had projected, and the stock was rewarded. We view its current valuation of 9x estimated 2017 earnings as a bargain for a name that has produced a 14% rise in book value per share over the past 12 months. Management has been buying back shares, and the combination of a growing pool of insurance in force and fewer shares in the market could result in strong earning per share growth in the coming quarters.

An improved outlook?

The economic picture has brightened and investors of all stripes have benefited. However, valuations point to the easy money having already been made. Going forward, we believe fundamental analysis is required to uncover businesses serving unique niches, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow. In an Index-oriented investment world, we believe this is the best approach to producing superior performance over the long run.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 49 years of industry experience, 35 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is Vice President and Portfolio Manager of the Heartland Value Fund and its corresponding separately managed account strategy. He has 24 years of industry experience, 14 at Heartland.

Composite Returns*

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Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.

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†Composite return is net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988.
**Shown as supplemental information.

Past performance does not guarantee future results.

The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

The U.S. dollar is the currency used to express performance.

As of 12/31/2016, Trinity Biotech plc, RadiSys Corporation, Verizon Communications Inc., and Radian Group Inc. represented 4.3%, 3.5%, 0.0 %, and 4.3% of the Small Cap Value Composite, respectively.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

Economic predictions are based on estimates and are subject to change.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Sector and industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

There is no guarantee that a particular investment strategy will be successful.

Heartland’s investing glossary provides definitions for several terms used on this page.

Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.